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Cover Story : Imperfect Balance

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Despite four years of steady decline, the potential for the dollar to crumble is as great as ever.

October 19, 1987, was the worst day ever on Wall Street, at least in terms of market losses. The Dow Jones industrial average closed down 22.6%, surpassing the previous record one-day loss of 12.9% in the crash of 1929. Some analysts blamed the 1987 stock market crash on program trading, as computers simultaneously dumped large blocks of stock on the market. Others cited the deteriorating US trade deficit, which led Ronald Reagan’s treasury secretary, James Baker, to suggest the need for a decline in the dollar.

Almost 20 years later, market participants are still fretting about financing the record US trade and payments deficits. Nearly everyone agrees that the growing US current account deficit is not sustainable. There is less agreement, however, that a fall in the dollar would be sufficient to close the trade gap by making US exports more competitive in global markets.
“It would take a severe recession in the United States combined with US tax hikes to eliminate the trade deficit,” says Ashraf Laidi, chief foreign exchange analyst at CMC Markets US in New York. US imports are two-thirds greater than US exports. Since 2002, when the dollar entered a long period of decline, US exports have shown average monthly growth of 0.8%, while imports have increased an average of 1% a month. The weaker dollar clearly has not reduced the trade deficit in the past four years, Laidi says.

Laidi:If the Fed starts to cut interest rates, the dollar could take a big hit.

And while there are some parallels to 1987 in the markets, there are also some major differences. “There is now a bull market in bonds instead of a bear market,” Laidi says. “But there could be some stock market selling as a result of a drop in the dollar,” he says.

The current dollar decline could be more credible and durable than in the mid-1980s, according to Laidi. “For one thing, there are real alternatives to the dollar now, such as the euro and other markets and currencies,” he says. “What’s more, China holds so much US paper that it is beginning to shift its reserves away from the dollar.” Meanwhile, capital flows are bigger than trade flows, and US investors are diversifying their portfolios by buying more non-US stocks.

“While the trade deficit and macroeconomic developments were the main drivers of the dollar in the 1980s, the markets now are more currency specific and interest-rate specific,” Laidi says. “The focus is on foreign exchange reserve diversification, interest-rate differentials and differences in economic growth rates,” he says.

Surprisingly strong economic growth in Europe and the United Kingdom, followed by Switzerland and Japan, could provide the impetus for a further decline in the dollar, Laidi says. “But I am not expecting a further sharp drop in the dollar until the Federal Reserve starts to cut interest rates,” he says. “That’s when the dollar will take its next big hit.”

Comments from People’s Bank of China officials warning about the risk to Asian currency reserves from a further slide in the dollar suggest that shifts from the dollar are already under way, according to Laidi. Of China’s $1 trillion of currency reserves, about 60%, or $600 billion, are in dollars, he says. That dollar percentage is down from nearly 70% a few years ago.

Chinese officials are fully aware that diversification of the country’s reserve holdings will have a downward effect on the dollar, depressing the value of their reserves, Laidi says. Nonetheless, this shift is going to continue in the future, he says. “China is not going to sell its existing dollar reserves, but it will include more British pounds and other currencies, as well as gold, in its reserve holdings,” he says.

China is also expected to diversify the composition of the basket of currencies that it uses to determine the exchange rate of the yuan. Following the reform of the yuan exchange rate system in July 2005, which included a 2.1% revaluation of the Chinese currency, the yuan’s value is no longer pegged to the dollar. The currency basket will be changed to include more euros, Australian dollars, Japanese yen and Asian currencies and fewer US dollars, Laidi says.

The dollar may weaken, and fund managers will sell dollar-denominated assets, the People’s Bank of China said in its 2006 Financial Stability Report. The central bank said that if external capital stops flowing to the US, the dollar may face a significant decline, which could lead to interest rate increases and a slowdown in the US economy. “If the US current account deficit growth continues to be higher than GDP growth, the investment value of US assets will be questioned by global investors, and the willingness of investors to continue holding and buying US financial products may weaken,” the PBOC said.

Meanwhile, the Bank of Japan is continuing to reduce its holdings of US treasury securities, and China has been joined by central banks in the Middle East and elsewhere in diversifying reserves away from the dollar. At a time when the US must attract about $7 billion of capital from the rest of the world every business day to finance its current account deficit, even a modest decline in foreign demand for US assets could trigger a sharp drop in the dollar.

Michael Woolfolk, senior currency strategist at The Bank of New York, says the size and persistence of the US trade and payments deficits make it prudent for market participants to keep a close eye on the situation. The US current account deficit has reached about 7% of US gross domestic product, and anything above 5% is considered a danger zone. Woolfolk predicts, however, that capital inflows to the US from Asian central banks and oil-exporting countries of the Middle East will continue to support the dollar.

The US Treasury’s International Capital System (TICS) data show that China has been a consistent buyer of US bonds in 2006. “China and the US are in an almost painfully symbiotic relationship,” says Dennis Gartman, editor and publisher of the Gartman Letter advisory service, based in Suffolk, Virginia. “We all know the truth of the situation: The US runs an imbalance of trade with China, and China invests its profits with the US in treasury securities.”

Woolfolk: Capital inflows will continue to support the dollar.

The question is how long this will last and who benefits. “We will argue that it is to China’s benefit, for it relies on the US as the buyer of what it produces,” Gartman says. “China produces first; the US buys next,” he says.

In what has been dubbed Bretton Woods II, an informal currency arrangement, the US gets stable, low-cost funding for its trade deficit, and China creates employment opportunities for the masses who are leaving the countryside for jobs in its cities. While this arrangement cannot last forever, analysts say there is no real reason why it cannot continue for another

15 or 20 years.

“It is difficult to conjure up a scenario of a big portfolio shift away from the dollar in an environment of firm global growth, low volatility and declining barriers to global capital flows,” according to a report by Lewis Alexander, Citigroup’s chief economist. “Still, US deficits are unprecedented in size, and there are risks of a much deeper dollar slide,” the report says.
Large US current account deficits continue to put downward pressure on the dollar, which has declined in real, trade-weighted terms every year since 2002, despite relatively high US interest rates, according to the report.